How to Cushion a Bond Bubble Burst

By Sam Mamudi

Conventional wisdom is that bond prices are due for a fall, and that when it finally happens things could get messy. So what’s an income-seeking investor to do?

Well, if you listen to Art Steinmetz, chief investment officer at OppenheimerFunds, there are a few ways to try to mitigate the damage. Among his recommendations:

Buy senior floating-rate notes – Senior floating rate notes are bank loans that sit above high-yield bonds in a company’s capital structure. Holders of these obligations get repaid before high-yield-bond holders should a company go bankrupt. Yet these short-term notes also sport a wide spread over Treasurys.

Senior loans typically trade at a premium to high-yield bonds, but the popularity of high-yield bonds has whittled away much of that discrepancy, Steinmetz noted in a recently published research report. Accordingly, he points out, senior loans nowadays are even more attractive than high-yield bonds — and both assets are better than Treasurys.

Seek more risk, in other words, since the market is riskier than you realize anyway. His other calls are in a similar vein: Emerging-market bonds, earnings growth from European stocks and a wary investment in junk bonds. Also, think about US stocks.

Investors would still do well to own dividend-paying growth stocks, Steinmetz advises — especially shares of companies exposed to rising global income.

“Dividend payout ratios are low,” he says. “Either companies will invest this cash, and capital expenditures will rise, or there will be more pressure on companies to increase dividends.”

It all sounds fairly reasonable, as does his general point about bonds and and his particular caution regarding Treasurys.

“People are loaded to the gills with super-safe investments and they’re not recognizing that the definition of ‘super-safe’ has changed,” Steinmetz says.

Investors, he adds, “have to reframe their view of what fixed income can and can’t do. Bonds can’t provide income — the yield on the 10-year Treasury is below inflation. The Treasury is guaranteeing that you will lose money slowly, so forget income.”

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JANUARY 19, 2013 10:51 A.M.

Frank wrote:

A bubble occurs when the price of an asset rises wildly beyond its intrinsic value, or value in use. Prices of all sorts of assets, real and financial, contain an element of fantasy as a result of real or perceived differences among assets, fashion, emotion and what economists call preferences. Dan Fuss, vice chairman and portfolio manager at Loomis Sayles & Co points out, "It's hard for bonds to bubble. It's easy for them to go the other way but it's hard for them to bubble because you're dealing with fixed contracts."

As pointed out by Perry Mehrling, professor of economics, at Barnard College , the same “bubble inducing” conditions don’t exist for bonds as for stocks because bonds have different financial characteristics. For example, bond prices tend to be less volatile than stock prices. Bonds can be held for redemption to maturity so long as the issuer is solvent at the end of the term. Second, the aging of the population cushions bond prices by providing underlying final investor demand which emphasizes income rather than capital gains. Pension fund management favors bonds for similar reasons.

While bonds have their risks, they are unlikely to lose half of their value as did stocks during the crisis. If 10-year high-grade corporate bond yields rise to 6.0 percent, the price of a bond will drop but one could hold the bond to maturity and collect at par.

More important, the Fed’s “dealer of last resort” role as described by Mehrling suggests that the Fed will have to support Treasury and other asset prices until the dealer system begins to operate again — and, indeed, possibly longer. The Fed will have to support bond prices with low interests and other maneuvers in a way that allows the Fed to sell the assets on its balance sheet without affecting the price.

I recommend that Barron’s interview some knowledgeable sources on this subject and stop repeating the hysteria headlines de jour.

JANUARY 21, 2013 2:19 A.M.

FrankieB wrote:

Interesting analysis, thanks.

JANUARY 21, 2013 10:28 P.M.

John D. wrote:

"Bonds can’t provide income — the yield on the 10-year Treasury is below inflation."

Common meme these days: we're all supposed to act like the only bonds in existence are Treasuries.

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.